Fatal Legal Mistakes Business Owners Make: Failing to Segregate Business Funds and Enterprises
This is the third in a 10-part series exploring legal mistakes that can be fatal to a business (even a seemingly well-established one). The illustrations and guidance provided are designed to help you spot these mistakes early. Each of these mistakes is preventable with proper planning and preparation.
Last month, I discussed the dangers of failing to maintain corporate formalities. When properly incorporated and maintained, a corporation or a limited liability company can protect you from personal liability arising from owning and operating a business, but only if you also maintain corporate formalities and treat the business as distinct entity from your personal assets.
If you have gone to the effort to formalize your business through incorporation, be sure to treat the business like a real business. Keep business and personal finances separate by opening separate bank accounts for each entity and keeping them separate from each other. In addition, hold regular meetings of the shareholders, officers, and directors and properly record what’s discussed at those meetings. And don’t forget to file annual reports with the Texas Secretary of State as required and submit franchise tax reports to the Comptroller, even if no tax is due. Corporations should also keep updated all contact information on file with the Secretary of State as needed, including the appointment of a registered agent (which will be discussed in detail in a future article).
So, you’ve taken the steps to properly incorporate your business and open separate bank accounts. Congratulations! This article will discuss how to properly segregate business funds and enterprises so as not undermine the very reason you created the business in the first place.
Read on for an illustration of how easily mistakes can arise, how fatal they can be for even the most successful business, and how to avoid them entirely with dedicated planning.
Mistake 3: Failing to Segregate Business Funds and Enterprises
When you operate too many business ventures out of the same company, you place all of your ventures at risk. Business owners who make the effort to set up a formal business entity often fail to plan ahead when their business ventures start veering away from the main enterprise. As the below illustration shows, it’s often unintentional at first, but if you fail to properly segregate your business enterprises into distinct entities (and, likewise, separate those enterprises’ funds), a court and creditors may find it easy to go after all of the business’s assets to cover a single enterprise’s liabilities.
Growing up, Pete and Fred were as inseparable as two brothers can be. Not surprisingly, when Pete and Fred entered the business world, they did so as partners. Fred learned of an opportunity to import inexpensive furniture from Asia, which the brothers sold to their college classmates. Upon graduating, the brothers rented and opened a small shop to sell their wares.
Pete had read enough small business articles to know that forming a corporation was the appropriate thing to do to protect his and Fred’s personal assets. As soon as they opened their first shop, Pete and Fred founded P&F Enterprises, Inc.
The brothers made a good team, and P&F Enterprises prospered. As they opened their second and then third store, it became obvious to them that additional opportunities within their furniture sale model might be worth pursuing. Some of the furniture they now imported was more expensive than the cheap stuff they had found while in college. Pete saw that P&F would sometimes lose customers who couldn’t afford their prices and Fred was told by a few store clerks that customers frequently asked whether they could pay for the furniture over time. This led Fred to explore and ultimately create a financing division to support the furniture sales. The financing division became its own profit center as more customers than they expected chose to finance their furniture purchases.
As P&F Enterprises continued to prosper, Pete and Fred hired more employees to oversee their stores so that they had time to travel to Asia to do some of their own furniture finding. In just a few years of frequent travel, several foreign contacts put them in touch with some clothing manufacturers. Pete and Fred had never thought about importing clothing – furniture was really their thing – but after exploring the margins and analyzing the market desire for the clothing they had found overseas, they thought it worth starting a clothing import division.
The clothing was wildly popular, particularly with young people. Soon P&F had a second chain of stores, this time focusing solely on clothing. As P&F’s profits grew, the brothers purchased retail space for each of their store fronts in order to avoid the high rent costs in the cities in which they had opened stores. Eventually, Pete and Fred had seven stores total – four furniture stores and three clothing stores. Each store was located in a small plaza or stand-alone store front that P&F Enterprises also owned.
While cash flow wasn’t often a concern, after running P&F for seven years, it became obvious that furniture and clothing sales would ebb and flow on a somewhat predictable cycle. In some of the leaner months, it was helpful to have a line of credit to support payroll while Pete and Fred continued to accrue travel expenses. As the business grew, the brothers obtained increasingly larger lines of credit.
In year five of the clothing line business, clothing styles changed. P&F’s clothing line suddenly floundered. Initially, the brothers attributed the drop in sales to the cyclical buying seasons they had come to recognize, but after a time they concluded that the market had changed fundamentally. They cut prices hoping to recoup their costs, but the clothing sales never rebounded. Ultimately, they were forced to close one clothing store and, within eight months, the other two.
Fortunately, the furniture business remained profitable, and the financing division was a steady source of income. Pete and Fred thought the profitable divisions could cover the obligations of the clothing stores, including the outstanding amounts owed to their suppliers for the last round of shipments and the mortgage and tax payments for the three retail locations.
Their banker had different ideas. P&F had nearly $500,000 drawn on their line of credit when the bank refused to renew the loan. The bank had become concerned when it learned that all three of the clothing stores had closed. Despite the fact that the furniture division was spinning off enough money to cover the monthly loan payments, the bank saw three empty retail locations and outstanding clothing supplier debt on the business’s books as a substantial liability. The bank demanded the immediate payment of the P&F’s entire obligation. Worse, the bank threatened to bring suit and, if necessary, take possession of P&F’s furniture collections if Pete and Fred couldn’t promptly pay off the credit line.
When Pete and Fred finally called a business lawyer, they were in disbelief to learn that the bank could do what it had threatened.
How to Avoid Mistake 3
Pete and Fred had treated their business dealings as a single venture when it actually consisted of many discrete businesses. Each furniture store and clothing store was a separate business, each building a separate venture. Separating each store and building into a separate corporation or limited liability company would have allowed the brothers to treat each portion of their business enterprise as what it really was – a separate and independent business undertaking.
There’s no doubt that maintaining distinct corporate entities for every business venture can make for some administrative headaches, but those pale in comparison to the expense of having one or more profitable business ventures suddenly liable for the debts of the unprofitable one. Likewise, while borrowing power may also be slightly lower for any distinct entity, it may also prevent that business from getting overextended on its debt vehicles.
When expanding your business into new ventures, it’s always a good idea to separate the venture into its own entity. The separation will allow you to make business decisions based on the merits of each business unit, rather than simply absorbing the expense of an unproductive venture into the profits of a more productive one.
When separating business ventures, be sure to follow the advice from my second article – maintain distinct bank accounts and maintain all the corporate formalities to ensure that not only are your personal assets protected from any individual business venture’s liabilities, but that each of the businesses are insulated from each other as well. If one business venture owns the building out of which another business venture operates, ensure that a formal lease is in place between the entities. If one company owns the intellectual property and another company markets goods or services that incorporate that IP, make sure proper licenses are in place between the entities.
In the next article, I’ll address the fatal mistake of a business failing to use a registered agent.